Learning to Live With Volatility and Disorder

This commentary originally appeared at 8:08 a.m. EST on Nov. 19 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

One day, the sardines disappear from their traditional habitat off the Monterey, Calif., shores, the commodity traders bid the price of sardines up, and prices soar. Then, along comes a buyer who decides that he wants to treat himself to an expensive meal and actually opens up a can and starts eating. He immediately gets ill and tells the seller that the sardines were no good. The seller quickly responds, "You don't understand. These are not eating sardines; they are trading sardines!"

Five months ago, I was speaking to the legendary Ira Harris (one of the most influential Wall Streeters over the last 40 years; back in the day, he ran Salomon Brothers' Chicago office), who mentioned that he could not remember a time during his investment career when there was so much uncertainty as there is now.

Ira's fears of uncertainty (mentioned earlier this year) represent the reality of the times today. Human beings fear that which they do not know, be it economic, social, political, geopolitical or even environmental (especially of a climate kind).

The market's wild swings and Hurricane Sandy are the most recent reminders of the world's fragility -- it is a world far different than when my Grandma Koufax was investing years ago.

Over the weekend, Nassim Nicholas Taleb wrote a thoughtful editorial in The Wall Street Journal that underscores that investors must learn to live with disorder and volatility.

In economic life and history more generally, just about everything of consequence comes from black swans; ordinary events have paltry effects in the long term....

Modernity has been obsessed with comfort and cosmetic stability, but by making ourselves too comfortable and eliminating all volatility from our lives, we do to our bodies and souls what Mr. Greenspan did to the U.S. economy: We make them fragile. We must instead learn to gain from disorder.

Volatility and disorder are likely a constant state in a global economy that is experiencing a new normal that remains on tenterhooks, still experiencing the tail issues stemming from the last down cycle and, as a result, only experiencing a fragile trajectory of growth.

Below are Taleb's five rules for prospering in a world in disorder:

Rule No. 1: "Think of the economy as being more like a cat than a washing machine." Policy aimed at stability and the absence of pronounced cycles is misplaced. As Taleb writes, "The state should be there for emergency-room surgery, not nanny-style maintenance and overmedication of the patient -- and it should get better at the former." Cease bailouts and keep safety nets as long as they encourage entrepreneurs and do not increase dependency.

Rule No. 2: "Favor businesses that benefit from their own mistakes, not those whose mistakes percolate into the system." Certain industries -- such as the restaurant business (when their meals are poor in quality, they have to improve the quality in order to survive) or the airline industry (whose safety measures improve after each disaster) -- are anti-fragile. Success should be an outgrowth of adversity. By contrast, each bank failure hurts the entire system.

Rule No. 3: "Small is beautiful, but it is also efficient." Size often increases fragility. The elephant breaks his leg at the slightest fall, but the mouse is unharmed by a steep fall. (This helps to explain, in part, why we have more mice than elephants!) We need an economic system that distributes risk along a wide range of sources.

Rule No. 5: "Decision makers must have skin in the game." We ended up in the financial and economic soup in the last cycle because bankers had a "tails I win heads you lose" compensation system. Whether that compensation includes a large portion of stock or whatever it takes, corporate executives must have a significant and vested interest in the companies they manage. They must be accountable for lack of success and must suffer financially when there is failure to execute.

So, how do we incorporate Taleb's socioeconomic lessons into our investing playbook?

Many of my most successful hedge fund friends have made their fortunes in buying and holding -- namely, by discovering investment acorns that rise into mighty oaks. They contend that, regardless of the environment, there will always be those opportunities.

Many of these hedge-hoggers have prospered by bottoms-up stock picking and have often downplayed the macroeconomic backdrop.

But perhaps the landscape has changed and the investment fields are simply not as fertile as they were in the old days.

Are We Stuck in a Broad Trading Range Over the Intermediate Term?

Well, I don't know why I came here tonight I got the feeling that something ain't right I'm so scared in case I fall off my chair And I'm wondering how I'll get down the stairs Clowns to the left of me Jokers to the right Here I am Stuck in the middle with you.

I would conclude that, while my hedge-hogger friends might be correct -- though for many, it has paid mighty dividends -- the unique conditions that exist today make the harvesting of those great investments ever more difficult. Indeed, there are numerous fundamental, valuation, sentiment and technical factors that support the notion that both the upside reward and downside risk might be limited (over the intermediate term) and that, as Stealers Wheel sang, we are "stuck in the middle with you."

Investment Conclusion: How Should We Operate?

Generally speaking I would err on the side of conservatism.

Maintain lower than typical long exposure. For example, if your normal invested position is net long 70%, think about maintaining net longs of 40%-60%, depending on your risk tolerance.

Be careful of large, maturing companies whose time has passed. More often than not, they are value traps subject to disruptive competition. (See Taleb's rule No. 3 above.)

Be receptive to committing an expanding part of your investing portfolio to smaller and more disruptive stock positions -- Sourcefire (FIRE) comes to mind. (Again, see Taleb's rule No. 3.)

Reduce the amount of investing you do while expanding your short-term trading activity. Be more active in long and short rentals.

While being more active in trading, be more patient than usual in your longer-term investing and wait for your right pitch, both with regard to an earnings and price timing set up. Volatility and disorder are accompanied by repeated opportunities to capture attractive entry points.

Be more active on the short side. Volatility encourages disappointment for those companies' managements that are inflexible, that are unable to respond to shorter economic cycles, whose margins might come under pressure (and pricing power limited) and whose profit stream is vulnerable to an economic wind no longer at the global economy's back.

Avoid concentration by diversifying your portfolio across industry lines, and keep individual equity commitments lower as a percentage of your total investment book.

Learn to trade based on specific catalysts, ranging from generic industry developments, earnings and other factors.

In order to be a nimble trader you must learn how to buy red and sell green. To do that, you have to overcome your emotions and learn to acquire more of a contrarian streak.

The next thing investors can consider in terms of dealing with volatility, disorder and possibility of the emergence of more black swans is to be long gamma, but that will be the subject of a future column.

In summary, looking out over the next few years, as unappetizing as it appears to some, we must learn how to operate successfully in a trading-sardine market, not in an eating-sardine market.

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